U.S. Markets closed

Putting Equal Amount Of Eggs In Each Basket Reduces Risk

One of the first questions a novice investor should ask is, "How many stocks should I own?

IBD founder and Chairman William O'Neil advises investors that too much diversification dilutes profit. But too much concentration can be dangerous, too. He says investors with $20,000 to $200,000 should limit themselves to four or five well-chosen stocks.

Let's say you have $100,000 and you decide to own five stocks. You should allocate $20,000 to each position, assuming the general market is doing fine. If you spot a top stock breaking out, you might plunk the entire $20,000 into it, or you might scale in as it rises and presents add-on buying opportunities.

To illustrate the problems with too much or too little diversification, let's say you spotted SouFun Holdings (SFUN) just before it broke out July 16. It had excellent fundamentals and had set up in a solid base.

But it makes you nervous. You've never heard of it, it's Chinese and it runs some kind of real estate website. So you decide to put just 5% of your money — $5,000 — into it as it breaks out.

By Dec. 24 (when it reached its highest close of 2013), it had nearly tripled. Your $5,000 investment had turned into $14,900, bolstering your account to $109,900. You bet on the winning horse and gained less than 10%.

But if you'd been braver and put in $20,000, your investment would have been worth $59,600.

Along the way, you've come to think Chinese stocks are great. You spot NQ Mobile (NQ), which appeared to be breaking out of a high-tight flag Sept. 12. It's a sure thing, right

You put $40,000 into it. At first, your investment looks good as the stock runs up 20% in less than three weeks, falls back just below the and finds support at its 50-day line. Then it rockets to a new high, and you know it's going to make you so rich.

At its intraday high Oct. 21, you're up 29%.

Then the unexpected happens. Around midday Oct. 24, a short seller puts out a negative report. The stock plunges 47%. You've taken a 40% hit, assuming you did not get a chance to cut losses short. You lost $16,000 and your account now is at a deficit.

NQ was the trade from hell for many otherwise savvy investors this year. But if you'd maintained your discipline and put in just $20,000, the damage would have been painful, but less so.